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Malone's Starz Sells Bonds Lacking Protection

Demand for high-yield debt gives borrowers more power to dictate deal terms.

Starz LLC, the movie channel provider owned by billionaire John Malone’s Liberty Media Corp., is pouncing on unprecedented demand for junk bonds to sell $500 million of notes that lack standard bondholder protections.

Documents governing the terms of the debt are “flawed” and “highly off-market,” according to research firm Covenant Review LLC, putting bondholders in danger of being subordinated by new obligations or left without recourse if the company sells assets. Starz issued the debentures to facilitate a $1.8 billion dividend to Englewood, Colorado-based Liberty Media as part of a transition to becoming a publicly traded company.

“They took some liberties,” Robert Matz, an analyst at Covenant Review in New York, said in a telephone interview. Starz officials “can send money out of the company without the company ever earning a cent,” diminishing the cash available to meet interest payments, he said.

Malone is known for using complex tracking stocks and financial transactions to pursue tax benefits and make his companies and assets more attractive. Record low interest rates have increased demand for high-yield, high-risk debt, giving borrowers more power in dictating deal terms. Yields on junk bonds tumbled to 7.22 percent on Sept. 7, down from 8.75 percent a year ago and more than 20 percent in early 2009, according to Bank of America Merrill Lynch index data.

Companies owned by Malone “are notorious for shareholder-friendly transactions,” Spencer Godfrey, an analyst at Montpelier, Vermont-based KDP Investment Advisors Inc., said in a telephone interview. In the absence of a sale of the company, “I imagine at some point they’ll revert to dividends and share repurchases,” he said.

Starz’s ratio of debt to earnings before interest, taxes, depreciation and amortization will be about 3 times following the spinoff, which it will maintain through 2013, according to a Sept. 5 Standard & Poor’s report. The company’s Ebitda will exceed interest by 7 times.

The company said in a Sept. 5 investor call that it was committed to maintaining a leverage ratio below 3 times, according to Godfrey. Starz also said that aside from a $1.8 billion payment to Liberty Media it will not make additional material distributions to shareholders.

A call to Eric Becker, a spokesman at Liberty Media, wasn’t returned.

‘Standalone Structure’

Liberty Media plans to spin off Starz, a competitor of Time Warner Inc.’s HBO, by year-end, it said in an Aug. 8 statement. The split is structured to be tax-free to the movie channel provider’s shareholders.

“This standalone structure is the first step to unlocking the real potential growth opportunities for Starz,” Chris Albrecht, chief executive officer of Starz, said in an Aug. 8 earnings call. The spinoff “allows us to build a more appropriate capital structure and provides us with the currency to explore potential strategic alliances, acquisitions and other value-enhancing strategies.”

Starz, which operates the Starz, Encore and Movieplex channels, has been adding original television series after Albrecht, the former chief of HBO, took over in December 2009. Starz’s shows include “Boss,” starring Kelsey Grammer, “Spartacus” and “Party Down.”

The network carries films from Walt Disney Co., including the company’s Pixar animation studio, and Sony Corp., with recent titles including “Men in Black 3.” Starz provided streaming rights to those films to Netflix Inc. before that deal expired in February.

The 7-year notes are rated Ba2, the second-highest level of speculative-grade, by Moody’s Investors Service and an equivalent BB at S&P. Proceeds will be used to retire the company’s $500 million term loan, helping lower the rate on its $1 billion revolving credit facility, according to KDP’s Godfrey. The company plans to use about $680 million from its credit line in addition to cash to make the distribution to Liberty Media.

Starz priced the debt to yield 5 percent, according to data compiled by Bloomberg. That’s 0.62 percentage point less than the average for bonds with the same tenor and credit rating, according to Bank of America Merrill Lynch index data.

Note Terms

The terms of the notes allow Starz to issue at least $725 million of secured debt, according to Covenant Review. They also permit the company to pay dividends to shareholders or invest in unrestricted subsidiaries based on meeting a consolidated leverage ratio, as opposed to the standard use of a calculation related to net income and equity contributions.

“For a high-yield bond, you expect to see certain standard provisions that will protect how much debt can come ahead of you, how much debt can come alongside you and how much cash can escape the credit,” Matz said.

The covenants are also missing a standard trigger that allows bondholders to redeem debt at 101 cents on the dollar should Starz sell substantially all of its assets to a third party, Matz said.

“If you spin it off, it has more brand recognition,” Godfrey said. “Investors can see it from the top down and understand to a better extent what’s going on in Starz.”

While an acquisition by an investment-grade company may not trigger concern over the so-called change of control put, it may become an issue in the case of a leveraged buyout by a private equity company, he said.

Starz reported revenue of $403 million in the second quarter, unchanged from a year earlier, it said in an Aug. 8 earnings report. It had free cash flow of $225 million in the prior 12 months, and more than $340 million in 2011, according to KDP.

While the post-spinoff Starz “will be more focused on its core operations, the company could pursue acquisitions outside of cable networks and content generation,” S&P analysts Andy Liu and Naveen Sarma wrote in the report. “We view the company’s financial risk as ‘significant’ given the potential for sizable debt-financed acquisitions.”

Starz’s 20.7 million subscribers and Encore’s 34 million compare with 28.5 million for HBO and 21.6 million for CBS Corp.’s Showtime, according to researcher SNL Kagan. About 58 percent of revenue was generated by Comcast Corp., DIRECTV and Dish Network Corp., its three biggest distributors, according to the earnings report.

“You’ll see issuers like Liberty Media and aggressive sponsors trying to have all this flexibility,” Matz said. “It can be a detriment to bondholders because it allows them to do a lot more without the reins being pulled in.”

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